A Portrait of Hedge Fund Investors : Flows, Performance and Smart Money

We explore the flow-performance interrelation of hedge funds by separating the investment and divestment decisions of investors using a regime switching model. We report three previously undocumented features in hedge fund data. First, we find a weak inflow-performance relation at quarterly horizons together with a very steep outflow-performance relation. At annual horizons, these patterns revert. We attribute this differential response time of inflows and outflows to the combined effect of liquidity restrictions, high searching costs, and active investor monitoring. Second, consistent with the theory that performance persistence is more pronounced where money flows are least responsive, we find remarkable differences in persistence levels across horizons for the subsets of funds that experience inflows and outflows. Third, we show that limited response capacity precludes investors from investing in subsequent good performers. Conversely, investors appear to be fast and successful in de-allocating from subsequent poor performers. Our findings do not support the existence of smart money